In order for you to understand the difference between a professional investor and an amateur investor, it is imperative that you understand the psychology behind the two. The first step in understanding psychology for both investors is to comprehend their emotions. As human beings, we are designed to feel emotion; this enables us to quickly determine how we should react to various situations. Professional investors acknowledge the power of feelings and how they affect our decisions, and therefore make it a point to try to feel as little as possible in situations that can be a matter of life or death when investing. However, this is easier said than done. Amateur investors fail to acknowledge their emotions because they don’t recognize them as such, instead attributing their feelings to other causes or random impulses that have nothing at all to do with money or investment decisions. Ignoring one’s own emotions can cause them to feel lost if an investment does not turn out as planned, whereas professional investors realize that investments aren’t guaranteed; there’s always a chance of failure, but since they became aware of this possibility ahead of time, they were already mentally prepared for dealing with it in the event it happens.
Overconfidence Bias
Overconfidence bias is the tendency to overestimate one's own abilities, or to overestimate the likelihood of a positive outcome in investing. It can also lead to risky decisions or an unwarranted belief in one's own abilities. Overconfidence can be especially detrimental to investors when they are making portfolio rebalancing or asset allocation decisions, because it can lead them to take on more risk than they intend. The overconfidence bias often leads investors to think that they are better at stock picking than the market average, and thus less likely to underperform the market average.
There are three types of overconfidence:
Overprecision – Confidence in one's judgments is higher than the quality of those judgments warrants
Overplacement – Confidence in one's ability is greater than actual ability
Overestimation– Confidence that future events will unfold exactly as planned
Loss Aversion
Loss aversion is the tendency people have to prefer avoiding losses over acquiring equivalent gains: it's better to not lose $5 than to find $5.
Most studies suggest that losses are twice as powerful, psychologically, as gains.
For example, if you need to choose between a sure gain of $240 and a 25% chance to win $1000, most people will choose the sure gain. But when offered a choice between a sure loss of $750 and a 75% chance of losing nothing (and a 25% chance of losing $1000), most people will choose the gamble.
Another important aspect of loss aversion is the endowment effect. When we own something, it becomes part of us; we value our possessions more than outside observers do. This can lead us to make irrational decisions in pursuit of avoiding losses from selling our possessions.
Confirmation Bias
Confirmation bias describes a tendency to look for and interpret information in a way that confirms one's beliefs
Confirmation bias is a tendency to search for, favor, and use only information that confirms or supports one's preconceptions. This can lead to disastrous investment decisions.
Investors are bombarded with information from financial news, brokerage statements, the Internet, and other sources. We tend to be selective when processing this data, paying attention to certain patterns while ignoring others. In the context of investing and trading decisions, this can lead to confirmation bias by focusing on and remembering the evidence that supports a particular decision while failing to consider contradictory data.
A prime example of confirmation bias is anchoring. Anchoring occurs when we fixate on an initial piece of information (the anchor) and use it as the basis for making decisions regardless of contrary evidence.
For example, an investor may buy a stock based on an analyst's recommendation without looking at any other information about the company. The analyst provides the anchor for their decision — or in some cases their excuse for a poor decision — and they ignore any other clues that might suggest a different action.
Takeaway
Understanding these psychological biases can serve two purposes for investors. The first, and most obvious potential benefit is that they can help avoid making impulsive decisions in their investments that might lead to costly mistakes. Investors who are aware of the behavioral problems they are prone to will be able to work through their thought processes more deliberately, resulting in fewer emotional decisions. The second potential benefit of understanding psychology when investing is that it can also help you find opportunities based on your own accumulated knowledge or analysis without succumbing to the pitfalls of confirmation bias. Investors who understand their ability to be swayed by past success are able to keep an open mind to other possibilities. They can carry out further research or analysis on a particular investment opportunity, rather than immediately dismissing it because it doesn’t fit neatly with what they already know.